Go back and prepare payroll tax returns and W-2s to convert at least a portion of the distributions to payroll.

IRS hasn't caught that in years. They should go back and do payroll but probably not worth it. Advise client the problem, tell them you can file it as is and there is a (small) possibility that IRS will catch it and do it for them under audit and they might have penalties and interest associated with it.

Another alternative is to reclass it to contract labor and then on the individual side have them pick it up as SE income. Technically that is wrong but at least IRS is getting all their money - that one is easier to explain and get out of with them (I have).

"Another alternative is to reclass it to contract labor and then on the individual side have them pick it up as SE income"

So, there is time to do it wrong, but not time to do it right, because the IRS might not even catch it? Just confirming the thought process in use...

"and do it for them under audit and they might have penalties and interest associated with it"

Or, do it right.